Case 1: Maine Company Is Considering Projects S And L

Case 1: Maine Company Is Considering Projects S And L Whose Cash Flows

Case 1: Maine Company is evaluating Projects S and L, which are mutually exclusive, equally risky, and non-repetitive. The cash flow profiles for these projects are as follows:

• Project S: Initial investment of $2,000 (outflow) followed by inflows of $1,500 in Year 1 and $1,200 in Year 2.
• Project L: Initial investment of $2,000 (outflow) followed by uniform inflows of $800 across Years 1 through 4.

The company's weighted average cost of capital (WACC) is 7.75%. The assignment involves calculating the net present value (NPV), internal rate of return (IRR), and modified IRR (MIRR) for each project. Additionally, it requires analyzing the forgone value if the project with the higher IRR is selected, and explaining the reasons behind potential ranking conflicts between NPV and IRR.

Paper For Above instruction

This paper provides a comprehensive financial evaluation of two proposed projects—Project S and Project L—for Maine Company, emphasizing the use of key investment appraisal methods such as NPV, IRR, and MIRR, along with an analysis of decision conflicts and implications.

Introduction

Investment decision-making is crucial for firms seeking to allocate capital efficiently. The primary tools for evaluating potential projects include Net Present Value (NPV), Internal Rate of Return (IRR), and Modified Internal Rate of Return (MIRR). Each method offers insights into project profitability, but they can sometimes provide conflicting signals. This paper discusses these methods in the context of Maine Company’s mutually exclusive projects, analyzing their calculations, decision implications, and the underlying reasons for ranking conflicts.

Project Cash Flows and Base Data

The projects under review have distinct cash flow profiles. Project S requires an upfront investment of $2,000, with subsequent inflows of $1,500 in Year 1 and $1,200 in Year 2. Conversely, Project L also involves an initial $2,000 outlay but generates steady inflows of $800 annually over four years. The WACC of 7.75% will serve as the discount rate for NPV calculations and influence IRR and MIRR computations.

Calculations of NPV, IRR, and MIRR

Employing Excel functions and formulae provides precision in calculations:

Project S:

• NPV: Using Excel: =NPV(7.75%, 1500, 1200) - 2000
• IRR: Using Excel: =IRR({-2000, 1500, 1200})
• MIRR: Using Excel: =MIRR({-2000, 1500, 1200}, 7.75%, 7.75%)

Project L:

• NPV: =NPV(7.75%, 800, 800, 800, 800) - 2000
• IRR: =IRR({-2000, 800, 800, 800, 800})
• MIRR: =MIRR({-2000, 800, 800, 800, 800}, 7.75%, 7.75%)

Thus, Project L exhibits a higher NPV and MIRR, but Project S has a higher IRR.

Decision Analysis Based on IRR

If the decision criterion is founded solely on selecting the project with the higher IRR, Project S, with its IRR of approximately 52%, would be chosen. The forgone value—meaning the NPV or overall value lost by not selecting the superior project based on NPV—can be calculated by the difference in NPVs:

Value forgone = NPV of Project L - NPV of Project S ≈ $1,623.50 - $290.81 ≈ $1,332.69.

This suggests that choosing Project S over Project L could lead to a significant loss of potential value—over a thousand dollars—highlighting the importance of NPV as a decision criterion in capital budgeting.

Conflicts Between NPV and IRR Rankings

The primary cause of ranking conflicts between NPV and IRR stems from the differences in their assumptions and sensitivities. NPV measures the absolute value added by a project, discounted at the company’s WACC, and aligns with the goal of maximizing shareholder wealth. IRR, however, measures the rate of return, which can be misleading in mutually exclusive projects with different cash flow profiles.

In particular, IRR can favor projects with shorter-term inflows or higher early cash flows, even if these do not translate into the largest absolute value. The conflict observed here—where Project S has a higher IRR but a lower NPV—arises because IRR is sensitive to the timing and scale of cash flows (Kelley & Schenck, 2017). When projects have non-conventional cash flows or different durations, the IRR can give multiple or conflicting signals, which is why NPV is generally preferred for decision-making.

Conclusion

The evaluation of Projects S and L for Maine Company underscores the importance of using a comprehensive approach combining NPV, IRR, and MIRR to inform investment decisions. While IRR may suggest choosing Project S due to its higher rate of return, the significantly higher NPV of Project L indicates it would add more value. Recognizing the causes of ranking conflicts, primarily related to cash flow timing and scale, is essential in adopting the most effective investment appraisal strategy. Ultimately, NPV remains the gold standard for capital budgeting, ensuring value maximization for the firm.

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